1.

Introduction to Inflation

Inflation is defined as a sustained increase in the general level of prices for goods
and services in a county, and is measured as an annual percentage change. Under
conditions of inflation, the prices of things rise over time. Put differently, as
inflation rises, every dollar you own buys a smaller percentage of a good or service.
When prices rise, and alternatively when the value of money falls you have
inflation.
Inflation is a persistent increase in the general price level, and has three varieties:

o Demand-pull
o Cost-push
o Built-in.
Causes of Inflation
There is no single theory for the cause of inflation that is universally agreed upon
by economists and academics, but there are a few hypotheses that are commonly
held.
Demand-Pull Inflation
Inflation is caused by the overall increase in demand for goods and services, which
bids up their prices. This theory can be summarized as "too much money chasing
too few goods". In other words, if demand is growing faster than supply, prices will
increase. This usually occurs in rapidly growing economies. This theory is often
promoted by the Keynesian school of economics.
Cost-Push Inflation
Inflation is caused when companies' costs of production go up. When this happens,
they need to increase prices to maintain their profit margins. Increased costs can
include things such as wages, taxes, or increased costs of natural resources or
imports.

Monetary Inflation
Inflation is caused by an oversupply of money in the economy. Just like any other
commodity, the prices of things are determined by their supply and demand. If
there is too much supply, the price of that thing goes down. If that thing is money,
and too much supply of money makes its value go down, the result is that the
prices of everything else priced in dollars must go up! This theory is often
promoted by the Monetarist school of economics.

Measurement of inflation
Measuring inflation is a difficult problem for government statisticians. To do this, a
number of goods that are representative of the economy are put together into
what is referred to as a "market basket." The cost of this basket is then compared
over time. This results in a price index, which is the cost of the market basket today
as a percentage of the cost of that identical basket in the starting year.

In North America, there are two main price indexes that measure inflation:

o Consumer Price Index (CPI) - A measure of price changes in consumer

goods and services such as gasoline, food, clothing and automobiles.
 The CPI measures price change from the perspective of the purchaser.
U.S. CPI data can be found at the Bureau of Labor Statistics.
o Producer Price Indexes (PPI) - A family of indexes that measure the
average change over time in selling prices by domestic producers of
goods and services. PPIs measure price change from the perspective
of the seller. U.S. PPI data can be found at the Bureau of Labor
Statistics.
o You can think of price indexes as large surveys. Each month, the U.S.
Bureau of Labor Statistics contacts thousands of retail stores, service
establishments, rental units and doctors' offices to obtain price
information on thousands of items used to track and measure price
changes in the CPI. They record the prices of about 80,000 items each
month, which represent a scientifically selected sample of the prices
paid by consumers for the goods and services purchased.

2. Procedure to adjust inflation

Inflation adjustment, or "deflation", is accomplished by dividing a monetary time

series by a price index, such as the Consumer Price Index (CPI). The deflated
series is then said to be measured in "constant dollars," whereas the original
series was measured in "nominal dollars" or "current dollars." Inflation is often a
significant component of apparent growth in any series measured in dollars (or
yen, euros, pesos, etc.). By adjusting for inflation, you uncover the real growth, if
any. You also may stabilize the variance of random or seasonal fluctuations
and/or highlight cyclical patterns in the data. Inflation-adjustment is not always
necessary when dealing with monetary variables--sometimes it is simpler to
forecast the data in nominal terms or to use a logarithm transformation for
stabilizing the variance--but it is an important tool in the toolkit for analyzing
economic data. The Consumer Price Index is probably the best-known US price
index, but other price indices may be appropriate for some data. The Producer
Price Index and the GDP Implicit Price Deflator are some other commonly used
indices, and numerous industry-specific indices are also available. The U.S.
Bureau of Economic Analysis compiles a wide array of "chain-type" price indices
for various kinds of personal consumption goods. A chain-type index is one that
is obtained by chaining together monthly, quarterly, or annual changes in
relative prices that are adjusted for changes in the composition of the
commodity basket, so as to reflect changes in consumer tastes.
BREAKING DOWN 'Inflation-Adjusted Return
This real rate of return may be used to compare investments, especially those
across international borders, as each country's inflation rate is accounted for in the
return. Without adjusting for inflation, an investor may get an entirely different
picture from reality when analyzing an investment's performance. For example,
assume a bond investment is reported to have earned 2% in the previous year. This
looks like a gain, but perhaps inflation last year was 2.5%. Essentially, this means
the investment did not keep up with inflation and effectively lost 0.5%.

As another example, assume a stock returned 12% last year and inflation was 3%.
An approximate estimate of the real rate of return is 9%, or the 12% reported
return less the inflation amount.

Calculating the Inflation-Adjusted Return

Calculating the inflation-adjusted return requires three basic steps. First, the return
on the investment must be calculated. Second, the inflation for the period must be
calculated. And third, the inflation amount must be geometrically backed out of
the investment's return.

3. INFLATION ADJUSTED ECONOMIC LIFE OF MACHINE:

In any industrial/service organization, equipment/machinery

forms an important element. The productivity of any organization is a function of
many factors. It is largely affected by efficient and effective use of machinery and
equipment. So, operations and maintenance of these equipment are very
important to the organization.
A machine which is purchased today cannot be used forever.
It has a definite economic lifetime. After the economic life, the machine should be
replaced with a substitute machine with similar operational capabilities. This kind
of analysis is called replacement analysis.
The elements of costs involved in the replacement analysis are as follows:
1. Purchase cost (initial cost)
2. Annual operation and maintenance cost
3. Salvage value at the end of every year, if it is significant
The trade-off between different cost elements is shown in Fig1.3.

Fig1.3

From Fig.1.3 , it is clear that the sum of operation and maintenance

cost increases with the life of the machine. But the capital recovery with return
decreases with the life of the machine. The total cost of the machine goes on
decreasing initially but it starts increasing after some years. The year with the
minimum total cost is called as the economic life of the machine.
4. LIMITATION OF EXISTING MODEL:
In the case where the machine is replaced due to wear and tear, the following
costs are considered :
1. Initial cost
2. Operation and maintenance cost
3. Salvage value
In the existing model to deal with this type of replacement analysis, the
different cost elements are estimated without taking the effect of inflation into
account.
 The annual cost of operation and maintenance of the machine will
increase with the age of the machine due to decline in efficiency of the machine. In
the existing model, this increase in the operation and maintenance cost is taken
into account. But the increase in the operation and maintenance cost due to
inflation is not considered. Similarly, in the existing model, the salvage value is
estimated without taking into account the effect of inflation.
To highlight this particular fact on salvage value, an example is now
given.
The internal combustion engines (R.A. Lister) which were made in
England during pre-independence of India are still functioning well. Their resale
value is going up year after year. This may be partly due to inflation and partly due
to good quality of the engine parts. So, consideration of the effect of the inflation
on the economic life of the machine is a realistic approach.
In replacement analysis, a discount rate is usually assumed to reflect
the time value of money. First the concept of replacement analysis is
demonstrated without taking the inflation into account. Then, the same is
demonstrated by taking the effect of inflation into account. At the end, a
comparison between the two models is presented.
5. Economic Life Determination without Inflationary Effect:
The determination of economic life of a machine without considering the effect of
inflation is demonstrated using the following example.
EXAMPLE 1.2: A machine costs Rs. 5,00,000. Its annual operation cost
during the first year is Rs. 40,000 and it increases by Rs. 5,000 every year
thereafter. The maintenance cost during the first year is Rs. 60,000 and it
increases by Rs. 6,000 every year thereafter. The resale value of the machine is Rs.
4,00,000 at the end of the first year and it decreases by Rs. 50,000 every year
thereafter. Assume an interest rate (discounting factor) of 20%.
The method of finding the economic life of the machine with a discounting factor
of 20% at zero inflation rate is summarized in Table 1.2. From the table it is clear
that the total annual equivalent cost is minimum if the machine is used for 14
years. Hence, the economic life of the machine is 14 years.
6. Economic Life Determination with Inflationary Effect:
An average annual inflation rate of 6% is assumed for discussion. The
corresponding steps are explained in Table 1.3.
From the Table 1.3, it is clear that the total annual equivalent cost is
minimum if the machine is used for three years. Thus, the economic life of the
machine is three years.
Comparison of results
The results of the two approaches are summarized in Table 1.4 . From the
table, it is clear that the inflation has an effect on the economic life of the
machine. Since it is meaningful and realistic to analyze this type of problem by
considering the effect of inflation, the second approach should be used for such
analysis.
Results of the Two Approaches:
Table.1.4:

Approach Minimum annual Corresponding

equivalent cost(Rs.) equivalent cost life
(Rs.) (years)
Replacement analysis 2,50,456.00 14
without inflation effect
Replacement analysis 2,62,174.50 3
with inflation effect

EXAMPLE 1.3:
A company has received quotes for its recent advertisement
for the purchase of a sophisticated milling machine. The data are as per the
estimate in todays rupee value.
Machine X Machine Y
Purchase price (Rs.) 15,00,000 20,00,000
Machine life (years) 7 7
Salvage value at the end of 2,00,000 3,00,000
machine life (Rs.)
Annual operating & 3,00,000 2,50,000
maintenance cost (Rs.)

Assuming an average annual inflation of 5% for the next five years,

determine the best machine based on the present worth method. Interest rate is
15%, compounded annually.
Solution
Average annual inflation rate = 5%
Interest rate = 15% compounded annually
Machine X
Purchase price = Rs.15,00,000
Machine life = 7 years
Salvage value at the end of machine life = Rs. 2,00,000
Annual operating & maintenance cost = Rs. 3,00,000
The computation of the present worth of the annual operating and
maintenance costs of the machine X is summarized in Table 1.5.
Table 1.5:

The equation for the present worth of the machine X is

PWX(15%) = Purchase price
+ Present worth of inflated annual and operating cost
Present worth of the salvage value
= 15,00,000 + 14,83,680 2,00,000 (inflation factor)
(P/F, 15%, 7)
= 15,00,000 + 14,83,680 2,00,000(F/P, 5%, 7) (P/F, 15%, 7)
= 15,00,000 + 14,83,680 2,00,000 1.407 0.3759
= Rs. 28,77,901.74
Machine Y
Purchase price = Rs. 20,00,000
Machine life = 7 years
Salvage value at the end of machine life = Rs. 3,00,000
Annual operating & maintenance cost = Rs. 2,50,000
The computation of the present worth of the annual operating and
maintenance costs of the machine Y is summarized in Table 1.6.
Table 1.6:

The expression for the present worth of machine Y is

PWY(15%) = Purchase price
+ present worth of inflated annual and operating cost
present worth of the salvage value
= 20,00,000 + 12,36,400 3,00,000
(inflation factor) (P/F, 15%, 7)
= 20,00,000 + 12,36,400 3,00,000 (F/P, 5%, 7) (P/F, 15%, 7)
= 20,00,000 + 12,36,400 3,00,000 1.407 0.3759
= Rs. 30,77,732.61
Remark. Since the present worth cost of machine X is less than that of
machine Y, select machine X.
EXAMPLE 1.4
A company is planning to start an employee welfare fund. It
needs Rs. 50,00,000 during the first year and it increases by Rs. 5,00,000 every
year thereafter up to the end of the 5th year. The above figures are in terms of
todays rupee value. The annual average rate of inflation is 6% for the next five
years. The interest rate is 18%, compounded annually. Find the single deposit
which will provide the required series of fund towards employees welfare scheme
after taking the inflation rate into account.
Solution
Fund requirement during the first year = Rs. 50,00,000
Annual increase in the fund requirement = Rs. 5,00,000
Annual inflation rate = 6%
Interest rate = 18%, compounded annually
The computation of the present worth of the annual fund requirements is
summarized in Table1.7.
Table1.7:

The value of the single deposit to be made now to receive the specified series for
the next five years is Rs. 2,16,05,704.
7. PROJECT MANGEMENT:
INTRODUCTION:
A project consists of interrelated activities which are to be executed in a certain
order before the entire task is completed. The activities are interrelated in a logical
sequence, which is known as precedence relationship. An activity of a project
cannot be started until all its immediate preceding activities are completed. Some
of the typical projects are as follows:
Construction of a house
 Commissioning of a factory
Construction of a ship
Fabrication of a steam boiler
Construction of a bridge
Construction of a dam
Commissioning of a power plant
Shutdown maintenance of major equipment/plants
State level professional course admission process
New product launching
Launching a new weapon system
Conducting national elections
Research to develop a new technology
Construction of railway coaches
Project management is generally applied for constructing public utilities, large
industrial projects, and organizing mega events. Project management is considered
to be an important field in production scheduling mainly because many of the
industrial activities can also be viewed as project management problems. For
example, fabrication of boilers, construction of railway coaches, launching
satellites, product launching, organizing R&D activities, etc. can be viewed as
project management problems.
From the examples, one can recognize the fact that many of the projects are
repeated either by the same organization or by different organizations. Though
they are repeatable by nature, each project is unique in itself. In the case of the
new product launching of an organization, the first launching will be done at some
key city. Subsequent launchings will be done at other cities as per priorities fixed
by the marketing department of the organization. The project schedule which is
prepared for the first city cannot be applied to other cities without any
modification because the time estimates of different activities of the
project (product launching) will be different for each city due to environmental
conditions. In some cases, addition or deletion of some activities will take place.
So, if a project is repeated at a different place/different time, then a detailed
planning effort is required.
Project is represented in the form of a network for the purpose of analytical
treatment to get solutions for scheduling and controlling its activities. A network
consists of a set of arcs which are connected meaningfully through a set of nodes.
The precedence relationship among various activities of a project can be
conveniently represented using a network. So, the collection of precedence

Activity Description Immediate predecessor(s)

A Plan approval
B Site preparation
C Arranging foundation materials A
D Excavation for foundation B
E Carpentry work for door and window A
main
supporting frames
F Laying foundation C,D
G Raising wall from foundation to window F
base
H Raising wall from window base to lintel E,G
level
I Roofing H
J Electrical wiring & fitting I
K Plastering J,L
L Making doors and windows & fitting A
them
M White washing K
N Clearing the site before handing over M
relationships among various activities of a project is known as project network.
There are two methods of representing any project in the network form.
There are: (i) Activities on Arrows Diagram (AOA diagram), and (ii) Activities on
Nodes Diagram (AON Diagram).
The AOA diagram is commonly used in project management. This concept
is demonstrated through two examples.
EXAMPLE 2.1:
A construction company has listed various activities that are involved in
constructing a community hall. These are summarized along with predecessor(s)
details in Table 2.1.
Table 2.1:
Draw a project network for the above project.
Solution: The project network summarizing the precedence relationships of various
activities of constructing the community hall is shown in Fig. 14.1. In this figure,
activities A and B are concurrent activities. Activities C, E and L can be started only
after completing activity A. Activity D follows activity B.
Activity F can be started only when activities C and D are completed.
One can use similar logic to infer the remaining precedence relationships in the Fig.
2.1.

Fig2.1:
There are two main basic techniques in project management, namely, Critical Path
Method (CPM), and Project Evaluation and Review Technique (PERT). CPM was
developed by E.I. Du Pont de Nemours & Company as an application to
construction projects and was later extended by Mauchly Associates. PERT was
developed by a consulting firm for scheduling the research and development
activities for the Polaris missile program of US Navy. In CPM, the activities timings
are deterministic in nature. But in PERT, each
activity will have three-time estimates: optimistic time, most likely time, and
pessimistic time. There are some more advanced topics in project management
which are as follows:
Crashing of a project network
Resource levelling
 Resource allocation
These advanced topics are beyond the scope of this book.
8. PHASES OF PROJECT MANAGEMENT:
Project management has three phases: planning, scheduling and controlling. The
planning phase involves the following steps:
(a) Dividing the project into distinct activities.
(b) Estimating time requirement for each activity.
(c) Establishing precedence relationships among the activities.
(d) Construction of the arrow diagram (network).
The scheduling phase determines the start and end times of each and every
activity. These can be summarized in the form of a time chart/Gantt chart. For
each non-critical activity, the amount of slack time must be shown on the same
time chart. This will be useful at the time of adjusting non-critical activities for
resource levelling/resource allocation.
The control phase uses the arrow diagram and time chart for continuous
monitoring and progress reporting. In this phase, the network will be updated if
there is any variation in the proposed schedule.
9. GUIDELINES FOR NETWORK CONSTRUCTION
The terminologies which are used in network construction are explained as
follows:
Node: Generally, a node represents the starting or ending of an activity.
Branch/Arc: A branch represents the actual activity which consumes some
kind of resource.
Precedence relations of activities: For any activity, the precedence relations
provide the following information:
1. The activities that precede it
2. The activities that follow it
3. The activities that may be concurrent with it.
Network construction requires a detailed list of individual activities of a
project, estimates of activity durations, and specifications of precedence
relationships among various activities of the project.
Rules for network construction
The following are the primary rules for constructing an AOA diagram:
1. The starting event and ending event of an activity are called tail event
and head event, respectively.
2. The network should have a unique starting node.
3. The network should have a unique completion node.
4. No activity has to be represented by more than one arc in the network.
5. No two activities need to have the same starting node and the same
ending node.
6. Dummy activity is an imaginary activity indicating precedence
relationship only. Duration of a dummy activity is zero.
10. CRITICAL PATH METHOD (CPM)
As stated earlier, CPM deals with project management involving deterministic time
estimates. In this section, the concept of CPM is demonstrated through an
example.
EXAMPLE 2.3: Consider Table 2.3 summarizing the details of a project
involving 16 activities.
(a) Construct the CPM network.
(b) Determine the critical path.
(c) Compute total floats and free floats for non-critical activities.
Solution (a) The CPM network is shown in Fig. 14.3.

Fig2.3:
(b) Determination of critical path. The critical path of a project network
is the longest path in the network. This can be identified by simply listing out all the
possible paths from the start node of the project (node 1) to the end node of the
project (node 10), and then selecting the path with the maximum sum of activity
times on that path.
This method has several drawbacks. In a large network, one may commit
mistake in listing all the paths. Moreover, this method will not provide necessary
details like total floats and free floats for further analysis.
A different approach is therefore to be used to identify the critical path.
This consists of two phases: Phase 1 determines the earliest start times (ES) of all
the nodes. This is called the forward pass; phase 2 determines the latest
completion times (LC) of various nodes. This is called the backward pass. Let

Similarly, the ESj values for all other nodes are computed and summarized
in Fig.
Fig.2.4:
Also, TFij = LSij ESi, where LSij is the latest start of the activity (i, j).
LSij = LCj Dij
FREE FLOATS. It is the amount of time that the activity completion time can be
delayed without affecting the earliest start time of immediate successor activities
in the network.
FFi j = ESj ESi Di j
= ESj (ESi + Di j) = ESj ECi j
A summary of calculations of total floats and free floats of the activities is
given in Table.2.4.

Table.2.4:
Any critical activity will have zero total float (TFij) and zero free float
(FFij). Based on this property, one can determine the critical activities.
From Table 14.4, one can check that the total floats and free floats for the
activities (1,3), (3,4), (4,6), (6,9) and (9,10) are zero. Therefore, they are critical
activities.
The corresponding critical path is 1346910 (BEIMQ).
11. Gantt Chart:
A Gantt chart is a horizontal bar chart developed as a production control tool in
1917 by Henry L. Gantt, an American engineer and social scientist. Frequently used
in project management, a Gantt chart provides a graphical illustration of a
schedule that helps to plan, coordinate, and track specific tasks in a
project.
Gantt charts may be simple versions created on graph paper or more complex
automated versions created using project management applications such as
Microsoft Project or Excel.

A Gantt chart is constructed with a horizontal axis representing the total time span
of the project, broken down into increments (for example, days, weeks, or months)
and a vertical axis representing the tasks that make up the project (for example, if
the project is outfitting your computer with new software, the major tasks involved
might be: conduct research, choose software, install software). Horizontal bars of
varying lengths represent the sequences, timing, and time span for each task.
Using the same example, you would put "conduct research" at the top of the
verticle axis and draw a bar on the graph that represents the amount of time you
expect to spend on the research, and then enter the other tasks below the first
one and representative bars at the points in time when you expect to undertake
them. The bar spans may overlap, as, for example, you may conduct research and
choose software during the same time span. As the project progresses, secondary
bars, arrowheads, or darkened bars may be added to indicate completed tasks, or
the portions of tasks that have been completed. A vertical line is used to represent
the report date.

Gantt charts give a clear illustration of project status, but one problem with them
is that they don't indicate task dependencies - you cannot tell how one task falling
behind schedule affects other tasks. The PERT chart, another popular project
management charting method, is designed to do this. Automated Gantt charts
store more information about tasks, such as the individuals assigned to specific
tasks, and notes about the procedures. They also offer the benefit of being easy to
change, which is helpful. Charts may be adjusted frequently to reflect the actual
status of project tasks as, almost inevitably, they diverge from the original plan.

12. PERT (PROJECT EVALUATION AND REVIEW TECHNIQUE):

A PERT chart is a project management tool used to schedule, organize, and

coordinate tasks within a project. PERT stands for Program Evaluation Review
Technique, a methodology developed by the U.S. Navy in the 1950s to manage the
Polaris submarine missile program. A similar methodology, the Critical Path
Method (CPM) was developed for project management in the private sector at
about the same time.
A PERT chart presents a graphic illustration of a project as a network diagram
consisting of numbered nodes (either circles or rectangles) representing events, or
milestones in the project linked by labelled vectors (directional lines) representing
tasks in the project. The direction of the arrows on the lines indicates the sequence
of tasks. In the diagram, for example, the tasks between nodes 1, 2, 4, 8, and 10
must be completed in sequence.